INSIDER TRADING AND FINANCIAL FRAUD

Perhaps you have been reading about the massive effort by federal authorities to reign in the practice of insider trading. Insider trading is illegal when a person trades stocks in a public company on information that the public does not know. It is illegal to trade your own stock in a company based on this information but it is also illegal to give someone that information -- a tip -- so they can trade their stock. Insider trading breaks down the level playing field that should exist between those in the know and those who watch from the outside. It is unethical because the perpetrators abuse their position of trust and engage in self-serving behavior. It is the ultimate in egoism.

On November 23, 2010, government agents raided the offices of three large hedge funds to secure documents before they could be destroyed. The three hedge funds -- Level Global Investors LP, Diamond-back Capital Management LLC and Loch Capital Management LLC -- allegedly engaged in insider trading through consultants, investment bankers and hedge fund managers. The government could bring charges against the individuals and companies by the end of the year. A key issue will be whether the individuals involved had a duty not to disclose the information to others or use it for their own benefit, but, in fact, they did just that. For a charge of fraud to be sustained it must be shown that the offenders knew what they were doing. It wasn't an accident.

As the great Yogi Berra once said: "It's deja vu all over again." Remember Martha Stewart? Back in June 2002, she was investigated for using insider information obtained from stockbroker Peter Baconovic that Sam Waksal, the CEO of biotech company ImClone Systems, Inc., began selling his ImClone shares. The next day, ImClone announced that the Food and Drug Administration had rejected the company’s application for approval of its leading product, a medication called Erbitux. The government began to investigate Stewart’s ImClone trades. Stewart was charged with insider trading. However, the evidence was insufficient to sustain the charges and they were dropped. That wasn't the end of it for Stewart who was convicted on other charges related to her sale of ImClone stock, including obstruction of justice and lying to federal officials. Stewart was sentenced to, and has served, five months in prison and five months and three weeks of house arrest.

Insider trading is arguably the most selfish act that can be committed by a top official or agent short of the outright theft of resources from a company. It violates the fiduciary duty to external investors and can lead to the manipulation of stock prices. The fact that insider trading cases seem widespread is another strike against the financial services industry whose actions with subprime mortgages, selling securitized mortgage-based assets often to unsuspecting investors, and the use of credit default swaps to hedge their bets ushered in the financial crisis of 2008. An important question is when will these investment banks learn their lesson? Then again, why should they change their behavior given that in less than three years they are reporting record profits?